CHAPTER

Discounted Cash Flow

4 Valuation

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 Slide 2

Key Concepts and Skills

• Be able to compute the future value and/or
present value of a single cash flow or series of
cash flows
• Be able to compute the return on an
investment
• Be able to use a financial calculator and/or
spreadsheet to solve time value problems
• Understand perpetuities and annuities

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Chapter Outline
1. Valuation: The One-Period Case
2. The Multiperiod Case
3. Compounding Periods
4. Simplifications
5. What Is a Firm Worth?

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4.1 The One-Period Case

❑ If you were to invest $10,000 at 5-percent
interest for one year, your investment would
grow to $10,500.
$500 would be interest ($10,000 × .05)
$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:
$10,500 = $10,000×(1.05)
❑ The total amount due at the end of the
investment is call the Future Value (FV).
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 Slide 5

Future Value
• In the one-period case, the formula for FV
can be written as:
FV = C0×(1 + r)

Where C0 is cash flow today (time zero), and

r is the appropriate interest rate.

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 Slide 6

Present Value
• If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s dollars.

• The amount that a borrower would need to set

aside today to be able to meet the promised
payment of $10,000 in one year is called the
Present Value (PV).
Note that $10,000 = $9,523.81×(1.05).

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 Slide 7

Present Value

• In the one-period case, the formula for PV

can be written as:

Where C1 is cash flow at date 1, and

r is the appropriate interest rate.

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 Slide 8

Net Present Value

• The Net Present Value (NPV) of an
investment is the present value of the
expected cash flows, less the cost of the
investment.
• Suppose an investment that promises to pay
$10,000 in one year is offered for sale for
$9,500. Your interest rate is 5%. Should you
buy?

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 Slide 9

Net Present Value

The present value of the cash inflow is greater

than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.

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 Slide 10

Net Present Value

In the one-period case, the formula for NPV can be
written as:
NPV = –Cost + PV

If we had not undertaken the positive NPV project

considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less than
the $10,000 the investment promised, and we would be
worse off in FV terms :

$9,500×(1.05) = $9,975 < $10,000

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 Slide 11

4.2 The Multiperiod Case

• The general formula for the future value of an
investment over many periods can be written
as:
FV = C 0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.

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 Slide 12

Future Value

• Suppose a stock currently pays a dividend

of $1.10, which is expected to grow at
40% per year for the next five years.
• What will the dividend be in five years?

FV = C ×(1 + r)T
0

$5.92 = $1.10×(1.40)5

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 Slide 13

Future Value and Compounding

• Notice that the dividend in year five,

$5.92, is considerably higher than the
sum of the original dividend plus five
increases of 40-percent on the original
$1.10 dividend:

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

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Future Value and Compounding

0 1 2 3 4 5
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Present Value and Discounting

• How much would an investor have to set
aside today in order to have $20,000 five
years from now if the current rate is 15%?
PV $20,000

0 1 2 3 4 5

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 Slide 16

How Long is the Wait?

If we deposit $5,000 today in an account paying 10%,
how long does it take to grow to $10,000?

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 Slide 17

What Rate Is Enough?

Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of
your child’s education?

About 21.15%.

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 Slide 18

Calculator Keys
• Texas Instruments BA-II Plus
– FV = future value
– PV = present value
– I/Y = periodic interest rate
• P/Y must equal 1 for the I/Y to be the periodic rate
• Interest is entered as a percent, not a decimal
– N = number of periods
– Remember to clear the registers (CLR TVM)
after each problem
– Other calculators are similar in format

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 Slide 19

Multiple Cash Flows

• Consider an investment that pays $200 one
year from now, with cash flows increasing
by $200 per year through year
4. If the interest rate is 12%, what is the
present value of this stream of cash flows?
• If the issuer offers this investment for
$1,500, should you purchase it?

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 Slide 20

Multiple Cash Flows

0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41

1,432.93 Present Value < Cost → Do Not Purchase

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 Slide 21

Valuing “Lumpy” Cash Flows

First, set your calculator to 1 payment per year.
Then, use the cash flow menu:
CF0 0 CF3 600 I 12

CF1 200 F3 1 NPV

F1 1 CF4 800 1,432.93

CF2 400 F4 1

F2 1

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 Slide 22

4.3 Compounding Periods

Compounding an investment m times a year
for T years provides for future value of
wealth:

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 Slide 23

Compounding Periods

❑ For example, if you invest $50 for 3 years at

12% compounded semi-annually, your
investment will grow to

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 Slide 24

Effective Annual Rates of

Interest
A reasonable question to ask in the above
example is “what is the effective annual
rate of interest on that investment?”

The Effective Annual Rate (EAR) of interest is the

annual rate that would give us the same
end-of-investment wealth after 3 years:

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 Slide 25

Effective Annual Rates of

Interest

So, investing at 12.36% compounded annually

is the same as investing at 12%
compounded semi-annually.
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 Slide 26

Effective Annual Rates of Interest

• Find the Effective Annual Rate (EAR) of
an 18% APR loan that is compounded
monthly.
• What we have is a loan with a monthly
interest rate rate of 1½%.
• This is equivalent to a loan with an annual
interest rate of 19.56%.

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 Slide 27

EAR on a Financial Calculator

Texas Instruments BAII Plus

keys: description:
[2nd] Opens interest rate
[↑] [C/Y=] 12 [ENTER]
[ICON Sets 12 paymentsmenu
conversion per year
V] 18 [ENTER]
[↓][NOM=] Sets 18 APR.
[↓] [EFF=] [CPT] 19.56

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 Slide 28

Continuous Compounding
• The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C 0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately
equal to 2.718. ex is a key on your calculator.

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 Slide 29

4.4 Simplifications
• Perpetuity
– A constant stream of cash flows that lasts forever
• Growing perpetuity
– A stream of cash flows that grows at a constant rate
forever
• Annuity
– A stream of constant cash flows that lasts for a fixed
number of periods
• Growing annuity
– A stream of cash flows that grows at a constant rate for
a fixed number of periods
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 Slide 30

Perpetuity
A constant stream of cash flows that lasts forever
C C
C …
0
1 2 3

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 Slide 31

Perpetuity: Example
What is the value of a British consol that
promises to pay £15 every year for ever?
The interest rate is 10-percent.

£15 £15
£15 …
0
1 2 3

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 Slide 32

Growing Perpetuity
A growing stream of cash flows that lasts forever

C C×(1+g)
C ×(1+g)2
…
0 1 2 3

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 Slide 33

Growing Perpetuity: Example

The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of
this promised dividend stream?
$1.30 $1.30×(1.05)
$1.30 ×(1.05)2
…
0 1 2 3

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 Slide 34

Annuity
A constant stream of cash flows with a fixed
maturity
C C C C

0 1 2 3 T

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 Slide 35

Annuity: Example
If you can afford a $400 monthly car payment,
how much car can you afford if interest rates are
7% on 36-month loans?

$400 $400 $400 $400

1 2 3
0 36

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 What is the present value of a four-year annuity of
$100 per year that makes its first payment two years from
today if the discount rate is 9%?

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
 Slide 37

Growing Annuity
A growing stream of cash flows with a fixed
maturity
C C×(1+g) C
×(1+g)2 C×(1+g)T-1

0 1 2 3 T

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 Slide 38

Growing Annuity: Example

A defined-benefit retirement plan offers to pay $20,000 per
year for 40 years and increase the annual payment by 3%
each year. What is the present value at retirement if the
discount rate is 10%?

$20,000 $20,000×(1.03)
$20,000×(1.03)39

0 1 2 40

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 Slide 39

Growing Annuity: Example

You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?

0 1 2 3 4 5
$34,706.26
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 Slide 40

4.5 What Is a Firm Worth?

• Conceptually, a firm should be worth the
present value of the firm’s cash flows.
• The tricky part is determining the size,
timing, and risk of those cash flows.

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 Slide 41

Quick Quiz
• How is the future value of a single cash flow
computed?
• How is the present value of a series of cash
flows computed.
• What is the Net Present Value of an
investment?
• What is an EAR, and how is it
computed?
• What is a perpetuity? An annuity?

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